The Theory of Interest rate and Profit sharing

The Theory of Interest rate and Profit sharing_Money and Banking 

Liquidity Preference Theory:

According to liquidity preference theory lender lends money to borrow for the interest, and the interest is assumed to be a reward for parting with liquidity. On the other hand, if a person does not an important part with his savings, but uses them in his own productive activity, interest will arise. However, Keynesian theory is advanced to the classical theory of interest as the former is concerned with equilibrium points in the real economy sector. Thus, in the real world, the Keynesian theory is more realistic than the classical theory of interest than others.

Productivity Theory:

Productivity theory of interest is a reward for the profitable services in the capital of the production purpose. For example, a farmer having tractor to plow the field produces more as compared to the farmer who does not have it. Hence, interest is the payment for the productivity of capital.

The theory is criticized on the following:

• The theory only focuses on the causes for what the interest is paid but not on the determination of interest rates.
• It emphasizes on the demand of interest, but ignores the supply side of capital.
• It completely ignores how the interest is paid for the loan borrowed for consumption purposes.

Abstinence or Waiting Theory:

In the abstinence theory, interest is a reward for abstinence. During, people less consumes and save more income, and they lend this saving amount to others that is sacrifice of current consumption. Senior the expert advocated that abstaining from consumption is unpleasant. Abstinence theory was also criticized by some of the economists. According to the theory, an individual can feel unhappy if they save as it reduces consumption. However, rich people do not feel unpleasant while saving because they are financially capable to meet their requirements.

Austrian or Agio Theory:

Austrian theory is also called as a psychological theory of interest. John Rae and Bohm Bawerk in an Austrian school  advocated this theory. Therefore, future satisfaction has a kind of discount if compared with present satisfaction. The interest is the discounted amount that is required to be paid for inspiring people to invest or transfer their present requirements to the future.

However, the theory has been criticized by various economists:

• It arranges too much importance on the supply aspect and ignores the demand aspect
• It does not focus on the determination of rate of interest

Classical or Real Theory:

Classical theory is one of the most realistic in the economic development, it helps to measure rate of interest with the help of demand and supply factors. Demand refers to the demand of investment and supply refers to the supply of savings. According to this theory, the rate of interest refers to the amount paid for saving. Therefore, the rate of interest can be determined with the help of demand of saving needed to invest in the capital goods and the supply of savings.

The classical theory has been criticized by Keynes:

i.                    The classical theory assumes the full employment of resources which is not true in reality.

ii.                  The theory assumes that investment can be increased only when individuals reduce their consumption.

iii.                It indicates that there is no change in the income level of an individual.

Loan-able Fund Theory:

Loan-able fund theory refers to the view that time preference plays an important role in determining the amount of interest. This theory is also termed as neo-classical theory of interest. Nneo-classical economists predict interest is the amount paid for loan-able funds. According to the loanable-funds theory, the rate of interest is determined by the demand and the supply of funds in the economy at which the two (demand and supply) are equated. The supply of loanable funds (LS) is

LS = S + DH+ ∆M

Where S = aggregate saving of all households and firms net of their deserving

DH = aggregate dis-hoarding (of cash),

∆M = incremental supply of money.

The supply of loanable funds depends on the following reasons:

Savings:

The loanable funds in the type of saving are classified as ex-ante saving and robertsonian sense. Ex-ante saving refers to the saving that people plan according to their expected income and expenditure in the starting of a year or financial year. But, Robertsonian refers to the saving that is produced by taking the difference of previous period income and present period consumption. From the view of these two factors, the savings are different at different rate of interest.

Dishoarding:

It involves decline in the money stock of an organization. In the previous money stock, the liquidity of money is high that can be utilized at the present time as loanable funds. The higher the rate of interest, the more would be the money dis-hoarded.

Credit by bank:

It refers to the loan provided by the bank to the organizations. Banks can increase or decrease the money provide to an organization on the basis of certain criteria. The supply of loanable funds increases with the increase in the money created by banks. The supply curve is interest elastic for loanable funds. The higher the rate of interest, the more the bank would lend money.

Disinvestment:

Barber reported that the disinvestment is encouraged by a high rate of interest on loanable funds. When the rate is high, some, of the current capital may not produce a marginal revenue product to match this rate of interest. The demand for loanable funds depends on investment, consumption, and hoarding of income.

The Rational Expectation Theory:

Money and capital market are the efficient institutions for new information that affecting interest rate. The rational theory assumes that business and individual or rational agent, and they try to make optimal use of resources because of maximizing return. In rational expectation theory, the absence of new information previous interest rate will be the current interest rate.

  

Money and Banking

Suppose government need to borrow F unusual amount from the public for large budget deficits. As a result now the expected equilibrium loanable demand curves D_E.  Here the usual supply curve S_o and equilibrium will be IE while the loanable fund C_E will be equilibrium. The equilibrium rate and loanable fund move upward because the fund will be needed in the future.

Assumes:

1.      Money and capital market are highly efficient

2.      Market interest rate and asset pricing incorporate all relevant information quickly

3.       The forecasting market interest rate is presumed to be virtually impossible.

Limitations:

4.      Do not know very much about how the public forms its expectations

5.      The cost of gathering and analyzing information relevant to the pricing of assets is not always negligible

6.      Both the interest rates and security prices do not appear to display the kind of behavior implied by the theory

Theory of profit sharing:

Company pays their surplus amount to the share holder as predetermined rate as profit. The amount after deducting all cost it calls profit of the company. Profit maximization is the main goal of all profit oriented organizations. They are tending to reduce cost and increase profit. An Islamic perspective, interest is prohibited by the Islamic Shariah and Quran while the conventional banking system are highly motivated toward imposing high interest rate on their loanable investment. 

Modern Theories of profit:

Compensation Theory of profit: Profit is the supply price of business where business is the supplier of capital and the ability to control as well as maintain the organization for the production. It is functional theory of profit that is developed by the Alfred Marshall. Profit is the price of function of capital and this theory treats as a cost of production element.

Dynamic Theory of profit: It is a residual theory of profit that is held by J B Clark. According his explanation profit is a deposit and profit accrues because society is dynamic by nature. Profit reduces cost, on the other hand, capital supply increase by reducing interest rate. This theory is also called windfall theory of profit.

Criticism
Dynamic theory of profit completely ignores the future or uncertainty. Prof. Knight  explained the only those changes, which cannot be foreseen and provided in advance will yield profits and not others.

Monopoly theory of profit: In this theory, profit reduce because of monopoly market power. Monopoly creates barriers to entry new firm in the market.

Uncertainty theory of profit: Frank Knight shows that profit is the price for bearing uncertainty risk. Uncertainty depends on several factors such a test and preference, innovation, technological changes, natural disturbances etc.

Risk bearing theory of profit: According to Shackle, holds that profit is the reward of entrepreneur for the risk taking. Investor always profit oriented they working to meet their goal. Maximize profit and minimize cost can increase shareholder’s wealth.

Surplus theory of profit: A theory that is developed by Kal Marx. He explains in his book, surplus is value of differences between price and wages. It is also a residual theory of profits. 

The wage theory of profit: Taussig and Davenport, profit is wage paid to the entrepreneur or business organization for successfully accomplishing his service. According this theory, Business organization gets profit as wage, and the receivable amount can vary by the number of labor.

 

Marginal productivity theory of profit: by Chapman, Stigler, Stonier and Hague, the profit is a wage payment to the entrepreneur, and profit paid based on the marginal profit According to this theory, the profit distribution depends upon the marginal production. If the company realize greater the marginal production greater will be the profit.

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